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Delivering Results in Volatile Times

The financial markets’ movement in 2011 led many investors to seek stable income and steady business models; midstream MLPs and other partnerships benefitted from that interest.

Stephen Maresca, CFA

Morgan Stanley

212-761-8343

stephen.maresca@morganstanley.com

MLPs continue to trade better than broader energy … And the music is still playing for the gathering and processing (G&P) investment theme. Record processing margins, tight inventories, material ethylene feedstock cost advantage and new announcements of incremental steam cracker demand all bode well for the next couple of years.

We would look to add exposure to MLPs with contractual participation in attractive processing economics and strong infrastructure buildout stories.

***

Brian Watson, CFA

SteelPath

bw@steelpath.com

214-740-6051

For the year [2011], MLPs, as measured by the Alerian MLP Index (AMZ), provided a 7.2 percent simple return versus the almost perfectly flat simple return provided by the S&P 500 and, highlighting one of the sector’s key attributes, when including distributions or dividends paid, MLPs provided a 13.9 percent total return versus the 2.1 percent total return provided by the S&P 500.

The sector closed the year with a 6.1 percent yield versus the 6.2 percent yield at the beginning of the year, as distribution growth generally kept pace with price performance, helping to keep the index’s yield flat despite the price appreciation.

Individual name performance over the year varied dramatically with the larger-cap names outperforming materially, followed by smaller-cap or mid-cap names that were able to tout an attractive near-term distribution growth expectation. Left behind were those that reported any “bad news” or offered lower near-term distribution growth expectations. Highlighting the divergence in performance, though the index’s simple return was 7.3 percent for the year, the equal-weighted performance for the sector was only a 0.5 percent gain.

We believe some of the smaller-cap and mid-cap names left out of the year-end rally in the sector will play catch up in 2012. Otherwise, we believe the sector will continue to benefit from the buildout of natural gas liquids and crude oil infrastructure that really got underway in earnest in 2011. Similar to 2011, we believe average distribution growth for 2012 will be 5 to 7 percent with a bias to the high side.

We also believe MLPs will continue to gain investor attention as the sector offers an attractive distribution yield versus competing assets classes, while also offering the opportunity to capture price appreciation fueled by distribution growth that is somewhat decoupled from the broader economy.

Much of the capital spending and growth being captured by the sector is tied to the buildout of natural gas liquid and crude oil logistical assets, and the demand for these assets is driven by producer exploitation of new drilling technologies and a shift to liquids rich natural gas production. Neither of these trends is likely to change, even if GDP growth were to stall or disappoint current expectations.

Given we don’t believe the fundamentals of the midstream sector are particularly exposed to the vicissitude of the broader economy, we think the sector continues to offer investors an opportunity to capture some attractive current yield with price appreciation potential in a sector that has business risk, or fundamental business exposure that differs from perhaps a good portion of the average investor’s portfolio. Importantly, we believe the demand for additional midstream assets and services will continue to provide the sector attractive growth opportunities for some time.

Ethan Bellamy

Robert W. Baird & Co.

303-270-6322

ebellamy@rwbaird.com

MLPs outperformed all other asset classes but utilities, [while] 2011 saw the Chicago Board Options Exchange Volatility Index (VIX) spike to a peak of 48 on August 8 and rise above 30 for 75 days of the year.

Strong performance and “risk on” in 1H11 (Alerian MLP Index up 2.2 percent, S&P 500 up 5.0 percent) gave way to losses and “risk-off” in 2H11 (Alerian MLP Index up 1.7 percent, S&P 500 down 5.8 percent), driven largely by the sovereign debt crisis in the Eurozone, which has yet to be resolved and may continue to dominate the market in 2012.

Capital access and issuance [are] at record levels. Despite the volatility, we estimate that the energy income equity sector (MLPs, MLP funds and U.S. royalty trusts) raised a record $19.7 billion in 2011 in equity versus $12.9 billion in 2010 and $7.3 billion in 2009.

Record new issuance: MLPs and royalty trusts floated 67 new issues in total versus 60 in 2010 and 52 in 2009, the prior record year.

Our target on the Tortoise MLP Index (TMLP), which we view as the best index to track as a proxy for an MLP portfolio, is $375. Our $375 target implies 13 percent total return prospects versus the current $354 price and 6.5 percent yield on the index.

Regency Energy Partners’ (RGP) 3Q11 EBITDA of $112.3 million was in line with our estimate of $113.0 million and above the Street’s estimate of $107.3 million. Distributable cash flow (DCF) per unit of $0.47 was 0.3 percent above our estimate of $0.46, implying DCF coverage of 0.98x during the quarter.

Looking forward, we believe that the (MLP) asset class remains compelling versus other “total return” investments, as many of these same securities lack the magnitude of intrinsic value (and lower associated risk of cash flow facilitation) inherent in select MLP models. Thus, while valuations may appear in line on an absolute basis versus historical precedent, perpetuating low interest rates (on a relative basis) and tight credit spreads could support the case of incremental yield compression. As such, we believe the sector remains well positioned to outperform the broader market on a relative basis (inclusive of yield).

Our favorite names in the MLP sector are those that possess the following characteristics: geographic scale and asset diversity, stable/visible contracted cash flow from underlying assets, scope in backlog via organic initiatives, the financial/liquidity flexibility to facilitate growth and preserve existing cash flow streams, and sound management with a track record of execution. These attributes should combine to yield more risk-averse cash flow in the near term, with the potential for above-average relative distribution growth over the intermediate to long term.

Furthermore, the yield spread bifurcation across the asset class will continue to become more pronounced as those MLPs with the most advantageous weighted average cost of capital (WACC) structures continue to post relative outperformance with regard to the slope of future discounted cash flow (DCF)/unit growth. The partnerships that exemplify such characteristics are Strong Buy-rated Enterprise Products Partners (EPD), and Outperform-rated … Plains All American Pipeline (PAA) and Magellan Midstream Partners (MMP).

Examining yields during the month of November, the spread of the Alerian MLP Index (AMZ) to the 10-year Treasury tightened by 6 basis points from the start of the month as uncertainty and volatility remained on the minds of investors. Of note, Operation Twist continues to depress the Treasury curve, with particular emphasis on the longer end of the curve. For some perspective, the 10-year Treasury yield is about 100 basis points below last year’s levels, exemplifying the uncertainty felt throughout the market.

As of November 30, 2011, the AMZ’s spread to the 10-year Treasury was 438 basis points, or 128 basis points above the historical average of 3.10 percent. Even with the distortions in the Treasury market, MLPs still remain an attractive alternative in a low yield environment, as investors continue to show preference for the tax advantaged distributions and potential for above-average distribution growth embodied by MLPs.

Focusing on relative valuation vs. alternatives in today’s market, MLPs provide compelling income and a total return that we believe will outpace the broader markets over the long term.

Michael Blum

Wells Fargo Securities

212-214-5037

Michael.j.blum@wellsfargo.com

We hosted the 10th Annual Wells Fargo Pipeline and MLP Symposium in New York on December 6, 2011. With another solid year of performance (on a price performance basis, the Wells Fargo MLP Index is up 3.9 percent year to date, versus a gain of 0.3 percent for the S&P 500), interest in the sector is arguably at an all-time high, with the overall tone of MLP management teams extremely positive, in our view. There were 1,100 total participants, up from 965 in 2010.

As outlined in our presentation to kick off the conference, the themes that have prevailed for 2011 are likely to continue in 2012. MLPs are poised to accelerate distribution growth in 2012, supported by a combination of crude oil and natural gas liquids (NGL) infrastructure investments and acquisitions …

Given the improving outlook for the MLP sector, the mood was generally upbeat and positive, in our view. Key themes that emerged were: One, management teams reviewed the details of their organic capital budgets, as they are in the midst of adding new infrastructure to transport commodities to market. Much of this new infrastructure is scheduled to be placed into service during 2012-13.

Two, management and investors seem focused on what potential growth opportunities lie ahead in 2013-‘14 given that much of 2012-‘13 growth potential has been identified. Our takeaway is that management teams are already laying the groundwork for longer-term growth opportunities by making small investments to evaluate emerging plays and market opportunities.

Three, NGL market players remain positive on fundamentals and see additional growth opportunities over time. Four, crude oil infrastructure development may still be in the early phases of a major buildout, implying the potential for significant new investment opportunities.

The (ratings agencies) panel at the 10th Annual Wells Fargo Pipeline and MLP Symposium conference consisted of Ralph Pellecchia from Fitch Ratings (Fitch), William R. Ferara from Standard and Poor’s (S&P), and Steven Wood from Moody’s Investor Service (Moody’s). Key takeaways are as follows:

The panelists expect there to be substantial infrastructure opportunities (e.g., crude oil and natural gas liquids, NGLs) for MLPs and other midstream companies in areas like the Bakken Shale, which currently has only limited midstream infrastructure built to support regional production.

The rating agencies estimate that these infrastructure opportunities could approximate $100 billion over the next 10 years. Notably, the firms indicated that recent NGL projects are scheduled to take only two to four quarters to build, versus previous natural pipeline projects, which took two to three years to be completed. Thus, these NGL projects have a more positive impact on a partnership’s credit rating given the shorter lead time to bring the projects into service.

With liquids production growing across the country, processors have been in active negotiations with NGL logistics companies to secure adequate NGL takeaway capacity for future production. While takeaway capacity is likely to remain tight in 2012, most gathering and processing (G&P) companies have secured sufficient takeaway capacity on newly proposed “y-grade” NGL pipelines, which are scheduled to be placed into service in 2013.

According to our calculations, midstream companies have announced plans to construct approximately 1,085 thousand barrels per day (MBbls/d) of y-grade NGL pipeline capacity terminating at Mont Belvieu, Texas.

For 2011, there could be a total of 12 IPOs completed, which would be the most on record. The attraction of MLPs includes their healthy access to the capital markets and premium valuations relative to C-corps. Notably, 2011 will likely be a record year for equity issuance, in spite of the volatile backdrop for the overall capital markets this year.

E&P C-corps with midstream assets could consider the MLP structure to unlock the value of these assets. In addition, the MLP structure remains a viable monetization strategy for private equity. We expect to see more IPOs in the MLP sector in 2012 as midstream, upstream, propane, and other companies evaluate the structure. Notably, there were six IPOs in 2010 after zero transactions in 2009 and only three in 2008.

Porter Bennett of energy consultancy Bentek Energy was the keynote speaker during lunch at the conference. The firm remains decidedly bearish on natural gas prices and basis differentials, in our view. However, Bentek did note that basis spreads could widen longer term in certain regions as a result of incremental demand from power plants. On the basis of preliminary data, the company estimates that Utica production could increase to roughly 2-3 billion cubic feet per day (Bcf/d) by 2017 from 0 Bcf/d currently. On the NGL front, Bentek anticipates an oversupply of ethane beginning in 2014.

For crude oil, the consulting firm anticipates significant investment opportunities for midstream companies as domestic production growth resumes for the first time in two decades.

Recent advancements in drilling technology have made commercial production of crude oil from shale plays economic. After more than 20 years (1985-2008) of decline, crude oil production has increased at a three-year compound annual growth rate (CAGR) of 5.5 percent since 2008. Bentek estimates that domestic crude oil production and imports from Canada could increase to a record 11.5-11.8 MMBbls/d by 2016 (i.e., the highest level since 1972).

The expected growth in crude supply should provide midstream companies with significant new growth opportunities. Bentek noted that even accounting for announced and identified new crude infrastructure projects, pipeline capacity appears insufficient to transport all the expected growth in crude production to market, which would result in continued bottlenecks and price differentials (such as the recent WTI/Brent spread). As such, Bentek believes additional crude infrastructure investment will be necessary over time.

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